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A German recession would put the euro back in danger

Opinion: Weak Europe is finally pulling Germany down

By

MatthewLynn

Getty Images

The assembly line in Sindelfingen, Germany, where Daimler AG builds S-Class sedans.

Its football team brushes aside all opposition to win the World Cup. Its Chancellor Angela Merkel dominates the European continent. Its mighty export machine keeps its factories humming, racking up big trade surpluses, and laying the foundations for what many people regard as the world’s most successful economy. There is not much wrong with Germany right now — and plenty that is right.

And yet, look under the bonnet, and there are some troubling signs. Industrial production is falling. Exports are down. Wages are stagnating. The inflation rate is so low it may soon slip into outright deflation. By the third quarter of this year, it looks as if Germany will be in recession.

That will change the dynamics of the euro zone, and not for the better.

Until now, the single currency, while it has been a catastrophe for the peripheral nations of southern Europe, has worked well for Germany. And Germany is by far the strongest power within the European Union. Not surprisingly, it has been doing everything in its power to keep the euro
EURUSD, +0.03%
together.

But once it gets hits by the currency just like many others, that will inevitably change. With a weakening Germany, the euro will look a lot more fragile than it has for the past year.

The signs of a slowdown in the German economy are not hard to see.

Last week, we learned that industrial production — which matters a lot more in Germany than it does in most other major advanced economies — shrank by 1.8% in May compared with April. Construction, often a good leading indicator of where the economy is going, was down by 4.9%.

Both imports and exports fell in May, hardly an indicator of an economy that is booming. On an adjusted monthly basis, exports were down 1.1% month-on-month, as other countries stopped buying as many German-made cars and chemicals, while imports dropped by 3.4%, as factories looked at their order books and decided they didn’t need so many raw materials, while squeezed consumers did a bit less shopping. The country still racked up a big trade surplus — but there is not much good in that if all it reflects is that imports are shrinking faster than exports.

Other indicators are not much better. Inflation is slumping, as it is right across the euro zone. For June, it was running at annualized rate of just 1%, and in May it was only 0.6%. As a general rule, companies don’t moderate price rises because demand is too strong — usually it is because it is too weak. That was reflected in the retail sales figures for May. They were down by 0.6%, following a 1.5% fall in April.

Most economists are still forecasting a decent rate of growth of around 2% for Germany this year. But not everyone. High Frequency Economics is predicting a contraction in the Germany economy for the second quarter of the year. Keep that going for two quarters in a row, and that is a recession.

The bond markets, which are usually a lot better at spotting trouble ahead than most others, have already noticed that something is up. The yield on a 10-year bund, as German government bonds are known, have been falling steadily all year and it is now down to 1.2%, very close to its all-time low. Bond yields don’t fall when an economy is expanding strongly. They drop because the smart money thinks recession and deflation are just around the corner.

Yellen Wary of Job Market, Slow Wage Growth

(4:42)

It is not hard to figure out what is going wrong. There is a lot of hype about the formidable German industrial machine, and while it has many excellent companies, basically it is workshop for the rest of Europe. Of its exports, 69% go the rest of the continent. Its biggest trade partner is France, which alone accounts for 9.2% of German exports. Asia has been growing, but it still accounts for only 16% of what the country sells overseas.

And Europe, of course, is a terrible market right now, and not about to get better any time soon.

Just take France, for example. Since 40% of German gross domestic product is made up of exports, and a tenth of those go straight across the border to France, its neighbor by itself accounts for 4% of Germany’s GDP. And the French economy is stagnant, with sales and confidence slipping month by month.

So are many of Germany’s other markets, such as Finland or the Netherlands. Of its neighbors, it is only the U.K. that is growing at a respectable rate — but no matter how much the British love German cars they can’t bail out its economy by themselves.

In effect, the euro-zone crisis has caught up with its strongest economy.

That is going to change the dynamics of the single currency. Up until now, it has worked pretty well for Germany.

After reforming its economy in the 1990s, it was well placed to reap the rewards of the single currency, thriving on the back of a vast export market with a fixed exchange rate. In the past, neighbors such as France and Italy regularly devalued against the deutsche mark to remain competitive. With that option off the table, German industry powered ahead. Employment was strong, and so were company profits.

True, the Germans complained about the bailouts, and what they saw as subsidizing layabout southern Europeans. On the whole, though, they knew the euro worked for them, and they would put up with it so long as that was true. Within the EU, what German thinks matters more than any other country. It is the biggest and richest nation. So long as it remained supportive, the euro could survive.

But a recession will change that. If the euro crisis hits Germany as hard as it has all of peripheral Europe, then all bets are off. The single currency will start to look very fragile once again — and its long-term survival will start to be called into question.

It can survive a Greek or Portuguese downturn. But a German one would be very different.

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